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It seems to be a universal consensus that with the market marching higher good ideas are becoming rare. I agree, this isn't 2008, where literally buying anything that wasn't deep in debt did well, or 2009 where that strategy continued to work. My observation has been that obvious value is scarce, but there are pockets of the market where value continues to exist, smaller cap banking stocks is one of those pockets.

In the past two bank primer posts I discussed a specific aspect related to bank investing, in this post I want to profile a cheap community bank. The bank is First Northern Community Bancorp (FNRN). There are hundreds of little banks like this, cheap and safe, First Northern was chosen almost at random, but it's a great case study.

First Northern Community Bancorp is a small community bank located in Northern California. The Bancorp is a holding company for one subsidiary bank, the First Northern Bank of Dixon. The actual bank has a small number of branches, their first branch was established in Dixon in 1910.

Investment thesis

I value banks in a slightly different manner than most, I value banks like I value companies. I find a bank that's clearly undervalued, then I work to either confirm or deny the valuation. This is the opposite of someone who might research and value a company and once the valuation is done look at the market value. I start with the market value, I'm not looking for franchise companies, I'm looking for companies that appear cheap, and I want to confirm they actually are cheap, if so I invest. This means I don't have a watchlist of banks or companies I'd like to buy if the price were right. Rather I continually trawl low P/B stocks and pick up what's on sale that week or month.

Here are a few of the things that caught my eye:

P/B 77%

Increasing ROA and ROE in the face of a declining net interest margin

Overcapitalized

Low level of troubled assets

Keep in mind, this isn't the world's greatest bank, yet it isn't failing or losing money either. First Northern is a fairly stereotypical community bank. Given their situation I'd argue they should trade at least at book value, if not for more.

The research

There are probably as many ways to investigate a bank as there are bank investors, considering this is my blog you end up with my approach. I first like to take a quick look at a bank's assets, then quickly move onto their liabilities. My theory is if the bank has a costly funding structure, and onerous expenses it's not worth my time investigating the quality of their assets. To summarize, I glance at the assets and make sure nothing catches my eye, then I investigate their liabilities.

First Northern Community Bancorp's liabilities consist almost entirely of deposits, and a very small amount of 'other liabilities.' A bank has a few levers they use to affect their profitability, the cost of their funds, the rates at which they loan money, and their cost of doing business. For a community bank that mainly focuses on mortgage and consumer lending their lending rates are often set by the market. This means that expenses and deposits are the main factors driving profitability.

In the case of First Northern most of their deposits fall into the category of retail deposits, that is deposits by retail banking customers. They have a low amount of brokered deposits, which are often costly. But simply avoiding brokered deposits isn't enough, more than half of First Northern's deposits are interest bearing. It appears most of the deposits are in low rate money market accounts, the bank is paying a .17% rate on all of their customer deposits.

Nothing concerned was discovered with the bank's liabilities, onto their assets, mainly their loans:

Examining a bank's loans is always interesting, there are many lenders like First Northern who make most of their money by lending residentially. The more interesting banks are the ones who are very creative in their lending and able to boost rates. FS Bancorp comes to mind, they're a Washington community bank that has a very strong lending program to local contractors, their rate on earnings assets is 6.09%, quite a feat, but not without risk either. Other banks will have a small but thriving business doing auto lending which is profitable, or investment management, or something else.

Residential loans typically have the lowest rates, but are also safer. A $75k residential default is handled much easier than a $2m commercial default. Banks that can prudently lend commercially stand to earn more money, but also expose themselves to more risk. First Northern isn't a pure residential lender, they have a sizable exposure to commercial borrowers. They also have a somewhat sizable exposure to three risky categories, construction and land, farm loans, and farmland. All of those categories are famously cyclical, if the bank lent when the market was high their recovery in a crisis could be questionable.

For the inquiring type I have included a small business loan drill down:

To determine if the bank is lending appropriately we need to look at their asset quality stats. There are two measures to look at, non-performing loans to loans, and non-performing assets to assets. First Northern has .92% non-performing assets/assets, which is a desirable outcome.

The bank's non-performing loans to loans ratio is 1.62%, higher, but not a number to be concerned about.

There's also the possibility that the bank is over-reserved for loan losses, if this is true they could reverse their provision at some point in the future resulting in a sizable one time earnings gain.

You may have noticed that almost this entire post I've avoided discussing the bank's earnings. A bank's balance sheet is paramount to their survival, a bank's earning power can be derived from their balance sheet. A bank with a poor balance sheet will have poor earnings, and a bank with a strong balance sheet will be able to generate strong earnings. Overall First Northern's balance sheet is average, and their earnings are average as well. The bank has been profitable seven of the last nine years losing money in 2008 and 2009 along with the rest of the banks in the US.

The one last thing I want to mention with First Northern is their capital structure. The bank has common stock, no debt, and preferred shares outstanding. The bank took TARP funds during the financial crisis, and then used funds from the Small Business Lending Fund to repay their TARP sharse. The bank initially issued $22m worth of SBLF preferred shares, of which they repurchased $10m in Q1 of 2013.

In summary the First Northern Community Bancorp is not a franchise bank. They are a slow growing bank serving Northern California. They will never become a money center bank, and most likely will never have brand recognition outside of three counties, but even still they have a sound balance sheet, quality assets and are profitable. When all of these factors are considered together it's reasonable to say that the bank should trade for less than book value. They haven't destroyed book value, rather they've been growing it. I would never recommend building a concentrated position in a bank like First Northern Community Bancorp, but it seems like an investor could do very well building a portfolio position of 15-20+ banks with profiles like First Northern Community Bancorp.

Only in a perfect world do all of our investments work out the way we want. No amount of planning or research can protect investors against the future, which is one of the most unpredictable forces in existence.

Last summer someone recommended that I take a look at the First Bank of Delaware as an investment. I took a look and quickly passed. I saw a bank that was losing money at an increasingly fast rate, and that had experienced some legal issues in their recent past.

The bank was digging itself into a hole that seemed hard to recover from, that was until I found a news release on the bank's website that explained they were looking into the possibility of winding down operations and liquidating. Suddenly I was interested, here was a bank trading for $22m with a book value of $44m. The trade seemed attractive, especially with such a large discount to book value, if the company's book value was anywhere close to reality I had the chance to double my money.

The downside seemed somewhat limited as well, at 50% of book value what could possibly go wrong? What sort of event could destroy this investment? I was initially worried about a bad loan book, but then First Bank of Delaware sold their entire loan book to Bryn Mawr Bank at a 3% discount to book value. My biggest concern had been cleared up, investors were now set to double their money right?

Here are two spreadsheets I put together last summer showing the value of the bank:

At the time of my research the stock was trading at $2.00 per share, the investment value was straight forward.

What went wrong?

What I neglected to mention above is that the bank didn't willingly decide to enter liquidation, they were forced into it by the FDIC. The FDIC issued a consent order that forced them to either submit a plan of reorganization or to voluntarily liquidate. The company missed a few deadlines on submitting a strategic plan of reorganization, and was forced into liquidation. This should have been my first warning sign, that bank's management was unable to submit a plan of action to satisfy the FDIC's request. At the time I didn't think much of this, but in retrospect is speaks volumes to the speed and reactive nature of management.

The First Bank of Delaware's troubled past had finally caught up with them. In their recent history they had been known as a subprime enabler, they were a clearing bank for subprime credit cards. They were also involved in a supposed security incident where the bank processed a large number of fraudulent Visa and Mastercard transactions. The bank was also involved in a check cashing company from California that was accused of lending at usurious rates. And lastly the bank was involved in an online check cashing and payment system that was allegedly used to send fraudulent payments that they bank was aware of.

On the last point the bank was facing action from the US Attorney General regarding the check cashing scheme. Based on some cases and settlements dug up from the internet it seemed that the bank would be able to settle, and even in the worst case scenario I could imagine shareholders would end up with a small positive gain. I had estimated a settlement in the range of $1m-$5m, with a potential worst case scenario at $10m.

Shareholders never received the full story behind the fine, but the bank was slapped with a $15.5m fine for their involvement in the illegal check cashing scheme. My gut tells me that there was more to the story than just what the filings said, but unless a prosecutor's lips become a little loose we will never know.

The $15.5m judgement was 50% higher than my worse case guess, it knocked the value of the bank's equity from $39m to $23.5m. The bank had also incurred close to $5m in liquidation costs at this point as well meaning that their book value was further reduced to $18.5m. My initial investment was in a bank with $40m in equity at the $22m level. With book value reduced to $18.5m my margin of safety quickly vaporized.

When news of the US Attorney General's fine was released the stock sold down sharply, I realized that I had no hope of a gain on the investment and sold for $1.70 a share, locking in a 15% loss. It was shear luck that I was able to limit my loss to 15%, the stock continued to fall and I know a lot of shareholders who experienced a 50% loss on paper before their shares were converted into liquidating trust shares.

The company is still working through the liquidation. According to the latest mailing I received last week they have $1.37 in net assets per share, but it's very likely the company is over-reserving and might have a little bit more to distribute.

Lessons learned

It's always painful to review a losing investment, but I think the pain is necessary to improve our investment processes. There was no way I knew what the government fine would be, but I had enough warning signs that indicated I should beware.

My biggest mistake was ignoring the company's past. I glossed over their involvement in subprime lending, and questionable short term lending practices. Because the bank was liquidating I didn't think any of the past mattered, but it did. The past spoke to the quality of management, and to their character. The type of management who would willingly engage in illegal activities, or would turn the other way when illegal activities are occurring isn't one I want running a company I own. Whatever the bank actually did was egregious enough that the government didn't back down on their fine, they refused to negotiate a lower settlement with the bank.

My second mistake was that I estimated too many variables for this investment. At one level this investment was simple, $40m worth of value being liquidated at $22m. The gap between the two values was what the market was assuming a settlement plus some legal costs would be. I had estimated costs to be less, and while I believed my guess was scientific, it was after all just a guess. The best investments are ones where there are only one or two assumptions that need to happen for the investment to work in the investors favor. With the First Bank of Delaware there were many assumptions that needed to work as planned for me to earn a return.

I firmly believe that each loss in my portfolio has a lesson attached to it. I will never avoid losses entirely, but there is always something to be learned. Even if the lesson is something I can't avoid in the future, there is value in awareness.

There's a common market perception of net-nets. These companies are perceived to be failures, or on the bring of failure. The market with its great predictive power has deemed these companies worthless, and it's just a matter of time before reality catches up with the market's vision. At times the perception of net-nets does happen to be true. There are many net-nets bleeding cash that are on their way to see a judge, but there are many that don't fit the mold either. Some companies find themselves in a position where being smaller and at best average leads to investor neglect. Couple investor neglect with a large inside holder and eventually shares become illiquid. Small, illiquid, and boring can lead to an undervaluation, which is the case with Hammond Manufacturing (HMM/A.Canada).

Hammond Manufacturing is a Canadian company located near Toronto, Ontario. The company's address is in a small town, but appears to be about five freeway exits from the suburbs. They have locations worldwide including the UK, Australia, and Taiwan. The company produces enclosures, such as electrical box enclosures, enclosure racks, outlet strips and electrical transformers. The business qualifies as boring, I can't imagine anyone getting excited about industrial electrical box enclosure technology. I'm not even sure the word technology should be used, most of the company's products are bits of metal twisted in different directions.

Anyone looking for a moat isn't going to find it with Hammond, their net margin is around 2%, and I'd be surprised if there wasn't a Chinese competitor who manufactured each of their products. Yet in the face of producing a commodity item the company has been able to remain profitable in recent history, with the exception of 2009. In 2009 the company reported a small, $44k loss.

I pulled the company's sales, earnings and book value from their earnings releases on their website going back to 2007:

If Hammond were trading at book value or above the company wouldn't attract my attention, their results are average at best. But with the stock trading below book value, and below NCAV I'm much more interested.

The company's current assets consist mostly of inventory and receivables. The company's inventory is almost entirely finished products, presumably waiting to be shipped to customers or distributors. The company doesn't have much cash on hand, but this isn't surprising given that they also have some debt.

The company is selling for 88% of NCAV, a strictly mechanical investor might consider this over priced since it's selling for more than 2/3 of NCAV, and would potentially sell at NCAV. I'm not mechanical by any means, and I can see that there's a lot of opportunity here besides a straight NCAV play.

The company has a fairly sizable property holding, they hold almost $9m worth of land and buildings at cost. They also own a 50% equity stake in a piece of property in Georgetown, ON. The Georgetown property is undergoing environmental remediation, but they company plans on developing it when finished.

The company's assets are like the rest of this company, nothing spectacular, but worth much more than the market is pricing them at. The assets, especially the current asset coupled with the company's profitability history is what gives Hammond value.

Hammond has earned respectable profits since 2007, sales took a dip during the crisis but have recovered and grown. The company's profits have remained mostly flat, but they've been able to grow book value. I've discussed in the past how an average company with a growing book value can be a great investment, Hammond qualifies in that regard. The company has grown book value at 6.7% over the past six years. On the surface that figure isn't all that impressive, but investors have the opportunity to invest at 44% of book value. Investors are buying $2.71 worth of assets for $1.19, meaning their 6.7% growth is actually 15% growth on an investment at the current price. If the company performs in the future like they have in the past I will own something that is appreciating on my investment at 15% a year, a return I'm satisfied with.

While the company has a considerable margin of safety in regards to both market price to NCAV and book value, any discussion of the company should include a look at their liabilities.

The company carries $10m of bank debt which they use to finance their inventory. They also have a number of operating leases on their factories and warehouse locations. For the first six months of this year the company's interest costs were covered 10x by operating earnings, which is a considerable buffer.

In summary there is nothing spectacular about Hammond except for their price. The company is profitable and has been growing book value consistently, yet the market seems to believe they're only worth 44% of stated book and 88% of NCAV. Even with a liquidity discount, and an insider ownership discount it's hard to justify a low valuation like this. I'm happy with the discount the market is handing out, and I picked up shares when I first discovered the company. Hammond Manufacturing fits well in my portfolio.

The housing bulls are back; the housing bears are back. This stock is a rarity that will satisfy both housing bulls and bears. The stock a study in shareholder destruction, the power of a successful turnaround, and lastly the legitimacy of operating leases.

Homasote is a well known brand, they manufacture building materials and have been doing so for over 100 years. The company is very proud of their history, each annual report contains pictures of the company's products from the 1930s and 1940s, the latest has a copy of their original patent included. The company touts itself as America's leading green building products manufacturer. All of their products are manufactured with Homasote board which is 98% recycled paper fiber and 2% other materials, which they promise are natural and environmentally friendly.

The company consists of two divisions, a millboard division and an industrial division. The industrial division is the smaller of the two and creates items for product separation and breakage reduction.

The company's millboard division manufactures everything from sound insulation to concrete joint filler to forming board (Homex) to roof decking. They even manufacture Ice Deck, a covering for ice arenas.

One would think that a company heavily levered to the housing market would have reported enormous profits in the early part of the last decade. Instead the company has reported losses as far back as the eye can see. The company's last profit before 2012 was 11 years earlier in 2001 when they earned $4.46 per share. At that point they also had a book value of $24.91 per share. For the next 11 years the company consistently lost money, not small sums either, they routinely lost $1.5-2m a year on $18-20m of sales.

The company's results have been so terrible I can't do them justice with words, only their five year financial summary can tell the true story:

The astute reader will notice two things, the first is that the company's book value is a negative $14.73, meaning in 11 years the company had been able to destroy $39.64 worth of shareholder value. The second thing the reader will notice is that they earned $2.31 last year, and are trading for $4, for a trailing P/E of 1.73. On the basis of their trailing earnings the company is extremely cheap.

Investors priced the company for death, shares traded down to $.25 a share in 2011, for the 166 stock holders of record it's been a wild ride since then. Anyone crazy enough to buy at the low has a 16 bagger at these levels. Yet if Homasote is somehow able to sustain their turnaround the shares look cheap even now, at least when looking at earnings.

Before moving into the balance sheet, it's worth looking at what the company did to earn their profit this past year. They were not profitable due to record sales, rather they reduced their cost of goods sold. The company signaled last year that they're working on two initiatives, reducing energy usage, and selling to markets that need their products. It seems like a no-brainer to sell products to people who need them, but you'd be surprised at how many businesses do not do this.

Once the company completes their energy usage improvements it's likely COGS will be reduced again, and profits could potentially be sustainable. It's also worth noting that the company has a very small float, which means that each additional dollar of profit will result in a substantial gain in earnings per share. For example, if the company is able to reduce COGS by 5% through their energy investments EPS would almost double to $4.23 a share.

While the company's income statement has improved over the last year the same thing can't be said about the balance sheet. When I'm looking at a highly risky turnaround investment I want a considerable margin of safety to exist with the company's assets. If the turnaround fails and the company has no assets what's left for the investor? Usually a tax deduction and a memory that's hard to suppress.

Homasote's assets are what you'd expect for a manufacturing company, some cash, receivables, inventory and a lot of property, plant and equipment. The company's PP&E came at a cost of $47m and has been depreciated down to $7m. Maybe the silver lining is there is some hidden asset value in their real estate or buildings. The assets aren't the issue for Homasote, it's their liabilities.

The company has $8.13m in long term debt obligations as well as a $4.1m pension benefit obligation. Both the debt and pension obligations are onerous, last year interest expense alone was $466k, or 37% of their operating income. On the pension, the expectations are a bit high, the company expects the pension to return 8.5% a year on a 70/30 portfolio.

When I looked at the company's financials for the past year something caught my eye that I couldn't reconcile with the financial statements alone. The company's long term debt went from $1.8m to over $6m in a year. Normally this would be associated with a debt issuance, and as the company's debt account increased their cash account increase to keep the statement in balance. This wasn't the case, initially I couldn't figure out what changed outside of the increase in debt. Furthering the mystery there was no mention of proceeds from financing in the cash flow statement that matched the increase in debt.

The answer was found in the notes, up until last year the company had an operating lease with Caterpillar for machinery at their factory. For reasons not discussed in the annual report Caterpillar decided to terminate the operating lease and convert it into long term debt. Suddenly the off balance sheet operating leases appeared on balance sheet, and the company's financial situation looks much worse. The reality is nothing has changed between this year and last year, it's just that the debt that was hidden is now visible and sits on the balance sheet. For the curious the company increased their PP&E account to reflect that the leased machinery was now owned.

There's a lot of debate and discussion about whether operating leases should be considered debt. There are great arguments on both sides, but seeing what happened to Homasote makes the debate tangible. The lessor decided at their discretion to change the terms of the lease, canceling it and turning it into long term debt. Because the company relies on this machinery to manufacture their product they had no choice but to go along with Caterpillar's decision.

Homasote isn't the type of turnaround I'm willing to get involved with. There is no margin of safety in this stock. The price is cheap, but there is nothing to fall back on if they hit hard times again. Looking at their history it's not a question of if they'll hit hard times, but when will they hit them next? Maybe the company's changes to become profitable are sustainable and they will earn out their deficit. If they can do this it wouldn't surprise me to see the stock soar. But it's just as likely to end up in the bankruptcy courts as well.

Sorry for the lack of posts recently, we took a small vacation and went camping at Deep Creek Lake in Western Maryland. I read a few emails while away, but generally stayed away from technology which was nice. We spent a lot of time hiking and playing at the beach, I also had the chance to read a book How to Make Money with Junk Bonds by Robert Levine. This post isn't a book review, it's more a collection of thoughts and takeaways I had while reading the book.

The book itself is short and easy to read. I purchased my copy used off Amazon for $3.70 or so, which was worth it for the insights I had.

I never fully understood junk bond investing before reading the book, but I had always felt that there was a similarity between investing in junk bonds and investing in net-nets and deeply undervalued companies. I should point out that deeply undervalued, or deep value is a euphemism for distressed, unloved dead money investments.

A junk bond is a bond with a low rating, usually defined as a bond rated BB or below. Bonds are rated by credit rating agencies based on a number of factors. The idea in the book is to buy bonds of a low rating when they should really deserve a higher rating. An example of this would be to buy a B rated bond from a company that is actually a BB credit. If the analysis is correct eventually the bond will be upgraded and the price will rise accordingly. To put this into equity terms, the company's intrinsic value is BB (a higher rating) yet it's trading for less (the B rating).

Bonds are unlike equity investments in that there is a chart of standardized valuation guide. A company that meets certain qualifications is graded on a standard scale against other companies using the same metrics. This means that it's fairly easy to determine if a bond is trading below intrinsic value, an advantage for bond investors that equity investors don't have.

The parallels between junk bond investing and deep value investing are many. Beyond finally understanding what a value investing approach with junk bonds would look like, I had two takeaways from the book.

The first takeaway is the reinforcement that downside risk is extremely important. In the junk bond world a bond that defaults can fall 50% or more, while a mis-priced bond investment that works well could return 10%. That means that one default requires five successful investments to just break even.

There is a reason most companies trade at absurd valuation levels, there is always some problem, known or unknown. A company with a strong balance sheet, and considerable growing earnings isn't going to trade below NCAV or even book value. Stocks don't trade for low valuations because they're ignored either. A stock might appear small and have no interest, but the lack of interest is usually due to a lack of liquidity. A very small and undervalued stock with ample liquidity will be discovered quickly. All of this is to say that low priced stocks usually have a risk, sometimes a liquidity risk, other times a financial or business risk. These are real risks, and not every investment works out like the investor desires. Often risks that appear small become large quickly and can become losses.

When investing in distressed companies, or illiquid companies I am always looking at what my maximum loss could be. A net-net that's burning cash, or worse burning cash with debt could end up bankrupt and I could lose 100% of my investment. Net-nets that are well run and are profitable have a much smaller risk of total loss, yet I still need to be aware of what is possible. I aim to limit my losses on any particular investment. Even though I'm investing in the equity of companies, my style of investing isn't aiming for stocks that triple or quadruple. I'm more or less batting for singles and doubles, gains of 50-100%. A consistent approach to avoiding losses makes gains of 50-100% all the more powerful for the portfolio.

The second take away from the book was that risk can manifest itself in ways other than financial risk. Levine discusses three types of risks in junk bonds, business risk, financial risk, and liquidity risk. Financial risk is the most common risk we think about, it's the risk that a company levers itself up and can't handle the interest payments the debt incurs. A company with a great business model can end up in bankruptcy due to financial risk. My favorite example of this is local restaurants, something I'm sure is worldwide and most readers can relate to. Have you ever gone to a new restaurant in town that has a wait no matter when you go, has great food and a great reputation, then all of the sudden goes out of business? Everyone asks "how could it happen?" My answer is the same every time, too much debt, or expenses out of control.

Business risk and liquidity risk are just as real as financial risk, but often harder to detect. Business risk is related to the company's business model itself. Levine uses the example of phone books when he talks about business risk. No one under the age of 75 is using phone books anymore, and the decline clearly manifest itself in the results of phone book companies. Sales and earnings declined quickly pushing them into trouble.

For investors picking through deep value stocks I think business risk is the most pertinent risk. Some deep value companies are experiencing declining earnings, is that acceptable? Maybe they have assets that they plan to monetize that compensates for the declining business. It's also possible that a declining business could imperil the value of the company's assets as well.

In a perfect world I'd love to buy companies that are profitable with large asset undervaluations, these companies are rare, and when they exist they almost always encompass the third risk, liquidity risk. There is a reason a well run business can trade at a very cheap valuation, the reason is usually there is a small float, and the shares almost never trade. These companies are too small for institutional investors, and small fund can have trouble building a significant concentrated stake. These stocks are shunned by almost all investors except for a crazy few like myself. I regularly get emails saying I'm foolish for not concentrating myself in my best investments, but diversification is the investors friend if they wish to mitigate liquidity risk. If I put 25% of my portfolio into a very illiquid stock I could have problems when I need to sell 50% of my stake. If I put 1% of my portfolio into 25 illiquid companies with similar investment profiles I have a better chance of raising the cash I need. Additionally I don't concentrate my portfolio in just illiquid stocks, I maintain a number of listed holdings that I could sell easily if I needed. I have a range of liquidity in my portfolio, in that sense I diversify my holdings based on liquidity level.

I have written previously about how to think about investments as a bond investor. I think using a junk bond investor perspective is more fitting. Evaluate risks, work to eliminate them, and don't hesitate to take a gain when one comes. The last takeaway I had from the book is very fitting for deep value investors, make sure you're compensated for the risk you're taking. The book talks about the worst bond investments being ones where the yield isn't high enough to compensate for risks that are present. At times no yield can compensate for the risk, that's when it's time to pass. The worst investments are ones where an investor pays a B price for something that's CCC in quality.

If anyone is looking for a short, easy to read book on junk bonds that has a lot of cross over to value investing I'd recommend the book. I'd make one further recommendation, don't pay the list price, like any good investor buy cheap (used, or reseller).

Disclosure: If you buy the book through the link I provided I will receive a small Amazon.com commission.

Long time readers know that I have a strong affection for unknown and unloved stocks. Sometimes these companies make great investments, but no matter the quality of the company I love the process of researching these companies. For some reason I find it enjoyable to go hunting for hard to find information. At times the destination is worth the journey, but mostly the journey is enjoyable on its own.

I enjoy a good hunt, some people enjoy hunting down certain vintages of wine, for others parts for old cars, and for others memorabilia. I enjoy collecting annual reports for unlisted companies that are hard to obtain. The process is never the same, but usually follows a general flow. I purchase a single share with my broker. Then I contact the company and ask for a copy of the annual report, sometimes I'm ignored, other times I receive something in the mail a few days or weeks later. I usually need to furnish proof of shareholding, and other times I've had to register shares in my own name.

My hunt for the Buck Hill Falls annual report was as unusual as this company is. I purchased a share, but when I tried to contact their investor relations contact I was met with a full voice mail box. I found another number allegedly assigned to them, but it was disconnected. I didn't do anything further for months. Then out of the blue I received a letter from the company and a proxy voting form, but no annual report. I wrote a letter to the Chairman and sent a copy of my proxy as proof of shareholding, days later I was holding the annual report.

Buck Hill Falls is a private 4,500 acre resort community in the area of Pennsylvania called The Poconos. The Poconos are beautiful mountains, I've driven through the area, and vacationed there as a child. The area is close to New York, Philadelphia, and Scranton, but yet remote enough that it feels far away from civilization.

From the company's website their community looks very nice, they have a golf course, a pool, fishing, hunting, and hiking, as well as on site restaurants. The resort is completely private, which means they have to pave their own roads, and provide their own water service. I believe this is why the resort is public, they went public to raise capital for community improvements. There is a blurb in the 2002 Walkers Manual that mentions the company sold shares to residents and shareholders for $20 apiece.

From an investment perspective the company does appear interesting. They have a book value of $3.1m, which has just about doubled since 1998, which implies book value growth of 4.6%. The company is trading at a steep discount to book value, their market cap is $1.19m. The company trades for 30% of book value. Suddenly that 4.6% growth looks reasonable at a 70% discount, becoming 15% growth on an investment at today's prices.

The company has two classes of shares, Class A and Class B. The Class A shares were issued during a stock offering in the late 1990s at $20 a share. The shares are non-transferable unless they are converted into Class B stock. A resident or shareholder in 1997 who purchased stock at $20 has to convert their shares to Class B to liquidate at the current price of $9, quite a hassle to lock in a loss. My guess is most of the liquidity for this stock is coming from residents and former shareholders finally liquidating their positions.

The company earned a small net income of $54k last year, and $90k in 2012, but my sense is that the company isn't being run to maximize income, or shareholder value. Rather the purpose of the company is to support its residents. The company has a few million dollars in debt all related to infrastructure improvements. They are re-paving roads, re-paving parking lots, upgrading the swimming pool, and upgrading their sewer infrastructure. The problem for shareholders is none of these expenses do anything to actually increase profits. At the most these expenses are required maintenance to keep the value of the property stable. At worst they're frivolous expenditures that benefit residents and destroy shareholder value.

As I read and thought about the company I realized that while this is attractively priced it might never make a good investment. Even though the company has public shares, and public shareholders, the company's true owners are the residents. The company provides a way for the residents to own a piece of where they live and vote on certain matters. It's like a publicly traded homeowners association (HOA). I'm sure my realization isn't original, that's most likely the reason the company trades at such a depressed valuation.

An investor squinting very hard might see value in the company's water utility, or in the 4,000 acres of undeveloped timberland held on the books at pre 1940s prices. The question I ask is what good is 4,000 acres of timber if the company never plans to develop it, and only harvests a small portion each year? The company's assets might be valuable, and if they were all priced today the company might be selling at a ridiculous valuation of 5-10% of book value, but does that matter if the company never does anything with them? For me Buck Hill Falls will remain a fascination, but it's unlikely I will ever increase my one share position, and unless I continually write letters I might not even receive another annual report.